Posted almost 4 years ago

Mortgage Notes: The REI Strategy You Have Never Heard Of

POP QUIZ, HOTSHOTS!

Ok... by a show of hands how many of you out there know what a note is? Not many, huh? Ok... if I put the word ‘mortgage’ in front of note, now how many know what it is?? Ok, a few more hands went up.

Well you guys (and gals) have stumbled across the right article! Here, I will lay out the basics of mortgage notes and how to invest in them! But before we get started, let me introduce myself. My name is Terrence Evans and I have been a practicing electrical engineer for almost 25 years. I started Terreva Investments as a side gig a few years ago for the express purpose of buying and selling mortgage notes. I became interested in note investing for several reasons:

I can become the Bank of Myself! People are now paying ME instead of Wells Fargo or BofA!
There is less competition for real estate investing deals!
It is a great passive investment vehicle!
It is a great use of retirement funds from a previous employer’s 401(k) account!

So now, let’s dig a bit deeper so you can understand what mortgage note investing is all about!

WHAT ARE NOTES?

They are actually promissory notes, which are written promises by a person or business to pay a debt over time. The note includes the amount owed, the interest rate, the term length (usually in months), the monthly payment, and when the payment is due every month.

Figure 1: Mortgages and trust deeds secure promissory notes to real estate

Notes can be used for any type of debt - credit cards, auto loans, school loans, etc. Mortgage notes naturally apply to real estate debt. Mortgages are not notes but actually secure promissory notes to real estate. That way, if the borrower can no longer make payments or refuses to make payments, the mortgage (or deed of trust) can be used by the lender to take over the real estate collateral to settle the unpaid debt.

HOW DO YOU INVEST IN MORTGAGE NOTES?

How one invests in notes depends on the type of notes they prefer. From this point forward, I will be writing about first position notes on residential properties. Let’s define the 3 major types:

Performing (PN): The borrower makes his payments on time.
Non-Performing (NPN): The borrower has been delinquent on his payments. The amount of time of the delinquency can vary from a few months to several years.
Re-Performing (RPN): A hybrid of the two previous types. Re-performers start off as performers, fall into delinquency, and then become performing again over several payments.

Referring to Figure 3, notes are originated by banks and financial institutions to businesses and individuals for all sorts of purposes but here it is for the purpose of acquiring real estate. As long as the buyer keeps making his or her monthly payments, the note is considered performing, and that bank likely holds on to that note until paid in full. However, non-performing notes are often bundled by the banks and sold on the secondary market – where the biggest players are the government sponsored entities - Fannie Mae and Freddie Mac - and large hedge funds. Note investors, ranging from mom-and-pop shops like myself to large investment funds, can purchase the notes that these players make available on the secondary market. Once the purchase has been made, the note investor steps into the position of the originating bank and has the power to collect the debt that was owed.

Figure 2: Performing vs Non-Performing Note Comparison

The true power of note investing is that investors can purchase collateralized assets at a discount (see Figure 2) with a high yield, while avoiding day-to-day Wall Street volatility. To be clear, to buy a note is to buy the debt, not the actual property itself. Here are two examples of note investments using real numbers.

Example 1: Let’s say that I purchase a PERFORMING 1st position note on a home in Georgia for $85K. It has an unpaid balance of $100K and 17 years left on the note, and let’s also assume that the monthly payment (that I will now receive from the borrower) is $1,000 per month. Over this time, I will have collected a total of $204K, and my gross yield will be 12.4%. Let’s put this in a different context so it is easier to understand. If I had bought this note using $85,000 from an old, stagnant 401(k) account, I would have $204,000 (less expenses) after 17 years assuming that the note was paid in full.

Example 2: Let’s say that Jacqueline purchases an $80K NON-PERFORMING

1st position note on Chris’s home in Ohio for $40K (see Figure 3). It is worth $75K as-is, $125K after rehabbing the home. The borrower has not paid in 4 years and he has abandoned the property. In order for Jacqueline to get her investment back, she will have to take possession of the property. That is, she will either have to convince Chris to sign over the property through a deed-in-lieu or she would have to foreclose on the property. In Ohio, that can take at least 8 months and cost about $3K in legal fees. Once the investor takes possession of the property, she can quickly re-sell it to a rehabber for the $32K (74% return) gross profit. If she spends $30K to rehab the house himself, he will net $52K (71% return) in profits.

Figure 3: Lifecycle of a Bank Originated Performing Note That Later Turns into a Non-Performing Note

WHAT ARE THE ADVANTAGES WHEN COMPARED TO OTHER STRATEGIES?

Here are a few reasons why I LOVE note investing:

There are multiple ways to make money
Assets are purchased at a discount to what is owed and/or to the property value
It is suited very well for passive real estate investors
Note holders may not be responsible for taxes and upkeep of the property, compared with rentals
Property destruction or damage does not necessarily impede payments or threaten the overall investment.
It requires less day-to-day oversight, which is better suited for investors with day jobs or active lives.

WHAT ARE THE POTENTIAL GOTCHAS?

Note investing may not appeal to all real estate investors. Here are a few potential reasons why:

It is not suitable for investors who feel they must be local to their investment
It has a slower timeframe to gain possession of the property, if that is the end goal
Small investors generally cannot or are not advised to use leverage to purchase note assets. It is an all-cash business.
Short of blatant fraud committed by a seller, note buyers may not have much recourse against sellers.
The exact condition of the underlying property may be unknown at the time of note purchase.
There are no tax depreciation benefits

MULTIPLE EXIT STRATEGIES

When buying a rental home, there are not many different ways to make money. Either one must rent it out or put it on the market to sell. Same goes with purchasing a home to flip. You pretty much need to rehab and re-sell the home to recoup your investment quickly. However, there are lots of different ways (or exit strategies) to make money in mortgage notes. Because notes are bought at a discount, investors have more flexibility in what they are able to do:

Broker notes
Re-sell the note
Get the borrower to re-perform
Take the property back as a REO (real estate owned) via foreclosure or deed-in-lieu, allowing the investor to:
- Rent the property
Seller Finance the property
Wholesale to an investor
Rehab and re-sell the property
Set up a lease-option or lease-purchase
And more!

WRAPPING UP

Although mortgage note investing is not new, it is lesser known to the general public when compared to other real estate investing strategies. Note investors do not have TV shows on HGTV. The mundane tasks that note investors have to undertake – working with servicing companies and lawyers, performing desktop due diligence, and going through Excel spreadsheets - do not make for exciting TV. But there is a reason why there are always a few skyscrapers in each city with a bank’s name on them. Or why banks are given a lot of deference by the government during times of economic turmoil. It’s because they make tons of money, due in part to notes of all kinds that they originate and service. And that money keeps the economy moving along.

The way I see it, mortgage notes give RE investors a chance to make significant income without having to deal with toilets, trash, and tenants. This should be an important consideration given this current climate of pandemics and rent control. Mortgage notes are treating me well. In three years, I have used my notes to triple the value of my self-directed IRA account. This in turn has given me capital to purchase larger value notes on higher quality assets. I will be honest and say that if you are looking for a sexy, get-rich-quick scheme, this strategy will disappoint you. However, this strategy has been known over time to add a few commas and zeros to the bank accounts of several friends of mine. I encourage all to do your own due diligence and find out if note investing is a suitable strategy for you to build generational wealth. BE THE BANK!